In 1998, Warren Buffett found himself in a predicament. He knew that many stocks had become overpriced, including many owned through Berkshire Hathaway. He also knew that selling those stocks would require a substantial tax payment to the U.S. government, and it would be difficult to find other things to purchase that would create more wealth in the long run once you adjusted for the lower pot of money available after taking the tax hit.
Instead, Buffett pulled off one of the most excellently structured deals of his career. Seeing that Berkshire Hathaway was trading at 2x book value, he issued 18% of Berkshire’s stock to purchase the reinsurer General Re. The brilliance of this move is that: (1) Warren Buffett created value out of thin air by transacting away some of his stock during one of the rare times under his helm when it was expensive; and (2) he lowered his stock exposure by getting his hands on Gen Re’s $24.6 billion fixed-income portfolio that owned municipal bonds paying out 6% to 7%.
At the time, the press made fun of Buffett. They quoted his 1990s letters to Berkshire Hathaway shareholders and reminded the world that Buffett once said Berkshire Hathaway shares shouldn’t be given up because they are almost certainly going to be worth more than the acquired stock. Financial pundits called Buffett a fool for diluting the shareholder’s ownership stake by 18% when individual companies in the portfolio like Coca-Cola compounded at 30% between 1990 and 1998.
Buffett knew when to make an exception. Coca-Cola didn’t compound at 30% between 1990 and 1998 because it was growing profits by 30% per year. No, the excessive compounding was primarily the result of ballooning P/E ratio that had led to the stock trading at almost 60x earnings in the summer of 1998. Berkshire’s stock was subsequently in that rare place valuation wise where it did make sense to sell 18% of the business in a transaction that took advantage of the overvaluation.
We have now come full circle, and those who study Buffett closely can see that he is now treating bonds the same way that he treated stocks in 1998. The financial media hasn’t really picked up on this yet, but Warren Buffett has reduced Berkshire Hathaway’s bond exposure to $27 billion. The Gen Re acquisition of 18 years was almost the size of Berkshire’s cumulative bond holdings now despite vast growth in Berkshire’s insurance and other operations.
Right now, Berkshire has over $531 billion in cumulative assets. $27 billion is invested in the bond markets. That means Berkshire’s bond exposure is only 5%, a wildly low allocation for a company so heavily steeped in property & casualty insurance operations. By comparison, Berkshire’s 1986 portfolio consisted of almost 40% corporate and U.S. government bonds. Back in the 1980s, bond prices were on a three-year bull market run as interest rates declined and old bonds with higher interest payments saw their prices rise to offset this.
Now, Buffett is doing the opposite. By his actions, he is signalling that bonds are not the place for an investor to be. The good news is that we shouldn’t need Warren Buffett to tell us that long-term bonds are a bad deal. The current 30-Year Treasury pays out 3.2%. The historical rate of inflation in the United States is 3.5%. If you hold to maturity, you will lose thirty basis points just by maintaining your investment.
The security of guaranteed payments by the United States government is a toxic seductive that hides the risk of almost guaranteed purchasing power loss over the long haul. If you are investing in a taxable account, you could face taxes as high as 39% on your bond payments which would reduce your effective yield to 1.95%. If the price of everything around you rises by 3.5% per year, and you are collecting 1.95% to 3.2% on a particular investment, how can you do anything but grow poorer under such an arrangement?
Seth Klarman holds 40% of his portfolio in cash. Normally, I think that’s way too cautious because it carries such a high opportunity cost in foregone dividends, rent, interest payments, growth, and rising valuations. But I see more wisdom in his approach now than I have in the past, simply as a matter of probabilities that better investment opportunities lay ahead, especially in the fixed income sector.
Although most people find the stock market a scary place because the price of companies can fluctuate every day without predictability, I actually find the fixed-income markets much more treacherous because you can’t afford to pay. If you do something ill-advised like pay 30x earnings to buy Nike stock, it will eventually work itself out. It might take a couple years of earnings growth to catch up, but eventually you’ll see purchasing power gains because the core company has a double-digit growth rate.
You don’t get that same margin for error in the arena of fixed income. If a thirty-year bond pays 3.2% to maturity, it’s impossible to make more money than that if you hold it to maturity. That’s the promise. And in all likelihood, you’ll probably earn less as you may face taxes at the time of sale. If inflation delivers its historical 3.5% over the next thirty years, you will be guaranteed to end up poorer in exchange for your patience.
And the low yield of U.S. Treasuries has a domino effect because things like junk bonds offer 5-6% yields when they should be offering 9% to 10% yields.
I think Warren Buffett will eventually be proven right on this. You would need a sustained period of early 1930s deflation to achieve meaningful purchasing power gains. You would need inflation in the 1% to 2% range to achieve negligible purchasing power gains, and a 3% inflation rate would store your purchasing power over the long run without making you any richer as a result of your investment. The numbers overwhelmingly suggest that this may one of the worst times in the history of the United States to bet heavy on domestic bonds. Buffett’s uncharacteristic fire sale of bonds over the past five years reaffirms this point.